Is the bull market for bonds over? With the Federal Reserve poised to raise rates in 2017, should one sell their fixed income? Many sophisticated investors believe the answer to these two questions is a firm “No.” In any environment, bonds perform several roles in overall asset allocation. Additionally, not all bonds are hurt as rates rise, especially if rates rise more slowly than usual.

1. Sharp Rate Hikes Create the Risk of Negative Returns for Bonds

You may have seen headlines or tweets declaring that the bond bubble is about to pop, or that “Bondmageddon” is coming. However, the Fed is projecting a fairly gradual pace of hikes: three 25-basis-point moves this year. But bond investors expect a much more gradual path for rising rates, with only two increases priced into the futures market. In recent years, the Fed has often overestimated just how much it will raise rates, as the table below shows.

“Despite what the Fed projects it will do, I think it is more likely that we will only see one or two rate hikes this year,” says my colleague John Smet, a portfolio manager with The Bond Fund of America®.

Simple bond math implies that many bond funds could see little to no rate-driven losses — as long as hikes occur slowly. Let’s consider the Bloomberg Barclays U.S. Aggregate Index, a common industry benchmark. Given its yield, duration and other characteristics at the end of 2016, and with other factors constant, interest rates would need to rise 1.3% (equivalent to more than five 25-basis-point hikes) over the next two years before investors would experience a loss. That’s an even bigger rate increase than the market anticipates.

2. Higher Yields Mean . . . Higher Yields!

Most investors know that when yields rise, bond prices fall. But there’s some good news: “Our opportunity to invest in great credit stories at higher yields creates the opportunity for the shareholders of our funds to receive more income,” explains my colleague Karl Zeile, a portfolio manager with The Tax-Exempt Bond Fund of America®.

More yield helps to offset falling bond prices. For example, let’s say yields rise 1% over two years — about what the market expects. The table below shows that more yield can actually help to produce a positive total return, despite the bond facing a capital loss:

Another advantage is that higher yields lead to more robust demand for bonds. This in turn helps prevent yields from rising too quickly or too high. Higher yields for U.S. bonds will continue to entice foreign investors who face much lower yields in their local markets. Mutual funds, pension plans and large insurance companies are also likely to increase their fixed income investments as yields rise.

3. Broader Market Risks Persist

The equity bull market has been strong recently, largely based on optimism for U.S. policy changes and potential infrastructure stimulus. But uncertainty — in the form of greater geopolitical risk and the potential for increasing friction regarding global trade and immigration — is clouding the global economic outlook. This creates an obstacle for aggressive Fed tightening and reinforces the need to hold bonds that can protect a portfolio by diversifying equity risk and preserving capital.

The administration’s most bullish policy goals are months or quarters away from being enacted, despite the market’s pricing in positive impacts. Some policies could even create headwinds to growth. Moreover, the geopolitical climate is providing more policy questions than economic answers. In today’s interconnected markets, a disruption or weakness overseas often has the potential to negatively affect U.S. markets and companies.

Investors are prudent to consider the implications of higher rates. However, they are also prudent to consider the risks to global markets. These should not be ignored or underestimated. Thus, I believe owning bond funds that can take advantage of higher yields and provide protection from market shocks by maintaining a low correlation to equity is as important as ever.

Close x

Sign up now to get industry-leading insights and timely articles delivered weekly to your inbox.

You may also like

Disclosure

Figures shown are past results and are not predictive of results in future periods. Current and future results may be lower or higher than those shown. Share prices and/or returns will vary, so investors may lose money. Investing for short periods makes losses more likely. View fund expense ratios and returns. View fund SEC yields.

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing. Securities offered through American Funds Distributors, Inc.

Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility, as more fully described in the prospectus. These risks may be heightened in connection with investments in developing countries.

The Capital Group companies manage equity assets through three investment groups. These groups make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organization; however, for securities with equity characteristics, they act solely on behalf of one of the three equity investment groups.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and not to be comprehensive or to provide advice.

Any reference to a company, product or service does not constitute endorsement or recommendation for purchase and should not be considered investment advice.

American Funds are intended only for persons eligible to purchase U.S.-registered mutual funds.

Past results are not predictive of results in future periods.

Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, “Bloomberg”). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

MSCI does not approve, review or produce reports published on this site, makes no express or implied warranties or representations and is not liable whatsoever for any data represented. You may not redistribute MSCI data or use it as a basis for other indices or investment products.